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Why Some Countries and Cities Are So Much More Expensive Than Others
By Derek Thompson
The Atlantic Magazine
Our special report on the world of prices wouldn’t be complete without asking, and trying to answer, a big, and surprisingly complex, question: How do pricey countries get that way?
Zenaide Muneton is a nanny in New York City. Last year, she made more than $200,000, Planet Money reports. Yes, with five zeros.
How in the world can Manhattan nannies be worth $200,000 a year? One answer is that they’re more talented than your typical babysitter. The highest-paid nannies can cook four-course macrobiotic meals and know their way around a Zamboni (those are actual examples of nanny skills). But the number-one reason why nannies in Manhattan can get paid $200,000 is very simple. Rich families can afford it. And in the market for locally-delivered services, like caring for a child, prices rise as high as the clientele can afford to pay.
What $200,000 nannies have to do with the price of tea in China
Six-figure nannies don’t rule the world, but they help explain the world of prices. On a global scale, the price of locally-delivered services, such as nannies and barbers, fluctuate wildly from country to country. A simple haircut in Uzbekistan is much, much cheaper than a simple haircut in Beverly Hills. But lots of goods can be bought and enjoyed thousands of miles away from where they’re made, like automobiles and paintings. If you’re in the market for an original Picasso, it won’t matter whether you buy the painting in China or in the United States. It will cost the same price anywhere, because the painting can be “consumed” anywhere.
So, some prices vary wildly from country to country, and some prices don’t. What’s the difference?
THE NANNY EFFECT
If the answer is obvious to you, then you just might be smarter than some of the 20th century’s most brilliant economists, who spent decades building a framework for finding out why some prices between countries (and even between cities in the same country) differ so dramatically. The most elegant of these theories is known, less elegantly, as the Balassa-Samuelson Effect, after two economists Béla Balassa and Paul Samuelson. The Balassa-Samuelson Effect is a mouthful. Let’s call it the “Nanny Effect.”
In a nutshell, the Nanny Effect says that the price of some goods — e.g.: Picasso paintings, barrels of oil, bricks of gold, and company stock — shouldn’t vary much by location, because it would create opportunities for arbitrage. If you bought a gold brick for $10 in Peru and sold it for $100 in the United States, Lima sellers would raise their price toward $100.
But most services aren’t like gold bars. They’re delivered locally and consumed locally. You’re not hiring a Bangalore nanny to look after your kids, and you’re not flying to Shenzhen for a haircut. From the dry-cleaner, to the restaurant, to the hairdresser, most of the jobs in a service economy have a local clientele. In cities where incomes are high, average price levels for these services are typically high. Where incomes are low, average price levels are low.
But how do incomes go from low to high? Balassa and Samuelson said it must come down to workers’ productivity, especially in the sectors that can “trade” their goods and services abroad. If a country gets better at making cars it can sell to foreigners for money, it gets richer. As income and investment flows into a country, incomes rise and prices rise across the board — even for the haircuts and the nannies.
WHY IS INDIA SO CHEAP? … AND WHY IS ZURICH SO EXPENSIVE?
On Tuesday, and my roommate Shyam emailed from Mumbai to brag about the cheap food. Ordering “a full lunch of a rice, naan and three curries for, oh, about $1 is pretty great.” It sure is, Shyam. But if he had visited ten years ago, it might have been closer to 50 cents. As India has become more productive over the last few decades, wages in the tradable sector (IT) rose, pulling up wages in the nontradable sector (waiters), and the currency has appreciated. There is a still a major price difference D.C. and Delhi. One dollar will pay for much less stuff in America than its equivalent in rupees will buy in India. But as Indian exports continue to grow, one should expect Shyam’s lunch to get more and more expensive.
There is much more to price levels than the Nanny Effect. Much, much, much more. Restrictive urban policy raises the price of rent in similarly productive cities. Energy policies and levies raise or lower the price of gas. Tariffs raise the price of imports. On a nation-by-nation basis, taxes restrain demand and subsidies increase supply on an idiosyncratic basis.
But perhaps the easiest way to mess with Balassa and Samuelson is for a government to manipulate foreign exchange rates. China, for example, is famous for pegging its currency to the U.S. dollar to make its exports more competitive. As a result, services in China are probably cheaper than they would be if the government weren’t actively trying to depreciate the currency. If you’re happily wondering “Why is China so cheap?” you should thank Beijing.
“The B-S Effect [er, Nanny Effect!] explains why on average, prices vary across countries, but in the short to medium run, the exchange rate will also determine how cheap or expensive different countries are,” economist Arvind Subramanian told me.
Another way to see this in action is to read the Economist’s latest cost-of-living index for cities, an sample of which are in the graph below. The top of the list was dominated by Switzerland (and, to a lesser extent, Japan and Australia). Why Switzerland?
Blame Greece and Germany. The debt crisis sweeping Europe has created a flight to safety to Swiss Francs, which are considered safer. As the Franc appreciated, prices have gone up compared to the euro and the dollar. Japan and Australia have also seen strong currency appreciation over the last few years, which made it relatively expensive for foreigners.
LAND AND RICHES
Even within a country, prices vary dramatically. The same beer might cost more downtown than in the suburbs. A barber might cost more in San Francisco than Detroit. Let’s conclude with another fundamental ingredient in prices. Land.
“Land is the key non-tradable good” in cities, Subramanian told me. It’s adheres to the Nanny Effect even more than nannies. If rents are going down in El Paso, you can’t take advantage of that fact while you’re living in Boston. That’s why housing rentals vary by thousands of percent among cities in different parts of the world. Rents rise when demand to live in an area goes up, and they fall when the supply of rental units outpace that demand. The price of real estate has a way of showing up in price tags all over the city. Ice cream shops, massage parlors, and architects charge more in cities with higher rental prices.
The unique case of Zenaide Muneton, our superstar nanny, is a story about land, to a degree, but it’s more a story about people. Manhattan has $200,000 nannies because that’s the little island where some of the richest and most talented people work and can afford the richest and most talented caretakers for their kids. If we had to boil all this — Balassa-Samuelson, Nanny Effect,exchange rates, urban policy — down to a sentence, it might be this: All things equal, prices rise fastest in the places where rich, talented people want to be.
This article available online at:
Copyright © 2012 by The Atlantic Monthly Group. All Rights Reserved.
Laura Tyson, a former chair of the US President’s Council of Economic Advisers, is a professor at the Haas School of Business at the University of California, Berkeley.
Are US Multinationals Abandoning America?
03 April 2012
BERKELEY – At a recent conference in Washington, DC, former Treasury Secretary Larry Summers said that US policymakers should focus on productive activities that take place in the United States and employ American workers, not on corporations that are legally registered in the US but locate production elsewhere. He cited research by former Labor Secretary Robert Reich, who, more than 20 years ago, warned that as US multinational companies shifted employment and production abroad, their interests were diverging from the country’s economic interests.
It is easy to agree with Summers and Reich that national economic policy should concentrate on US competitiveness, not on the well-being of particular companies. But their sharp distinction between the country’s economic interests and the interests of US multinational companies is misleading.
In 2009, the latest year for which comprehensive data are available, there were just 2,226 US multinationals out of approximately 30 million businesses operating in the US. America’s multinationals tend to be large, capital-intensive, research-intensive, and trade-intensive, and they are responsible for a substantial and disproportionate share of US economic activity.
Indeed, in 2009, US multinationals accounted for 23% of value added in the American economy’s private (non-bank) sector, along with 30% of capital investment, 69% of research & development, 25% of employee compensation, 20% of employment, 51% of exports, and 42% of imports. In that year, the average compensation of the 22.2 million US workers employed by US multinationals was $68,118 – about 25% higher than the economy-wide average.
Equally important, the US operations of these firms accounted for 63% of their global sales, 68% of their global employment, 70% of their global capital investment, 77% of their total employee compensation, and 84% of their global R&D. The particularly high domestic shares for R&D and compensation indicate that US multinationals have strong incentives to keep their high-wage, research-intensive activities in the US – good news for America’s skilled workers and the country’s capacity for innovation.
Nonetheless, the data also reveal worrisome trends. First, although US multinationals’ shares of private-sector R&D and compensation were unchanged between 1999 and 2009, their shares of value added, capital investment, and employment declined. Moreover, their exports grew more slowly than total exports, their imports grew more quickly than total imports, and the multinational sector as a whole moved from a net trade surplus in 1999 to a net trade deficit in 2009.
Second, during the 2000’s, US multinationals expanded abroad more quickly than they did at home. As a result, from 1999 to 2009, the US share of their global operations fell by roughly 7-8 percentage points in value added, capital investment, and employment, and by about 3-4 percentage points in R&D and compensation. The shrinking domestic share of their total employment – a share that also fell by four percentage points in the 1990’s – has fueled concerns that they have been relocating jobs to their foreign subsidiaries.
But the data tell a more complicated story. From 1999 to 2009, US multinationals in manufacturing cut their US employment by 2.1 million, or 23.5%, but increased employment in their foreign subsidiaries by only 230,000 (5.3%) – not nearly enough to explain the much larger decline in their US employment.
Moreover, US manufacturing companies that were not multinationals slashed their employment by 3.3 million, or 52%, during the same period. A growing body of research concludes that labor-saving technological change and outsourcing to foreign contract manufacturers were important factors behind the significant cyclically-adjusted decline in US manufacturing employment by both multinationals and other US companies in the 2000’s.
So, while US multinationals may not have been shifting jobs to their foreign subsidiaries, they, like other US companies, were probably outsourcing more of their production to foreign contractors in which they held no equity stake. Indeed, it is possible that such arm’s-length outsourcing was a significant factor behind the 84% increase in imports by US multinationals and the 52% increase in private-sector imports that occurred between 1999 and 2009.
To understand domestic and foreign employment trends by US multinationals, it is also important to look at services. And here the data say something else. From 1999 to 2009, employment in US multinationals’ foreign subsidiaries increased by 2.8 million, or 36.2%. But manufacturing accounted for only 8% of this increase, while services accounted for the lion’s share. Moreover, US multinationals in services increased their employment both at home and abroad – by almost 1.2 million workers in their domestic operations and more than twice as many in their foreign subsidiaries.
During the 2000’s, rapid growth in emerging markets boosted business and consumer demand for many services in which US multinationals are strongly competitive. Since many of these services require face-to-face interaction with customers, US multinationals had to expand their foreign employment to satisfy demand in these markets. At the same time, their growing sales abroad boosted their US employment in such activities as advertising, design, R&D, and management.
Previous research has found that increases in employment in US multinationals’ foreign subsidiaries are positively correlated with increases in employment in their US operations: in other words, employment abroad complements employment at home, rather than substituting for it.
Facts, not perceptions, should guide policymaking where multinationals are concerned. And the facts indicate that, despite decades of globalization, US multinationals continue to make significant contributions to US competitiveness – and to locate most of their economic activity at home, not abroad. What policymakers should really worry about are indications that the US may be losing its competitiveness as a location for this activity.
This article draws on “A Warning Sign from Global Companies,” co-authored with Matt Slaughter, Harvard Business Review (March 2012).
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